Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr.

Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

Lecture 26

Evaluation of Portfolio Performance

Size of professionally managed portfolios can be astonishingly large. For example, Fidelity family of
mutual funds has portfolios exceeding 100 billion dollar in market value of their securities. It is not
unusual for mutual funds having assets under management exceeding one billion dollar. In Pakistan
asset management companies (AMC) are formed; and a single AMC may launch and then manage
multiple mutual funds with varying investment strategies such as growth funds, equity funds, balanced
funds, income funds, money market funds, index funds, etc, to cater to the investment needs of different
investors among general public. Even in Pakistan NIT, an open ended mutual fund, has market value that
is more than one billion dollars. Also NAFA funds launched and managed by an AMC that is subsidiary
of NBP (National Bank of Pakistan) has assets under management exceeding 1 billion US dollar. As a
comparison, there are a few Pakistani industrial companies whose market value of equity is more than a
billion US dollar. With such huge amounts of financial assets under the control of AMCs, it is important
that their performance must be monitored closely because they are managing money of public . It is also
logical that based on the performance of portfolios (mutual funds) under their management, the managers
of AMCs should be rewarded or penalized. In this lecture issues pertaining to measuring the
performance of a portfolio, or more accurately performance of a portfolio manager, are discussed in some
detail.

How to evaluate performance of a portfolio?

Or more correctly, how to evaluate performance of a portfolio manager ?

This is an unsettled issue. If we compare realized R p of your portfolio with the realized R p of all other
professionally managed portfolios taken together, then question arises: which portfolio to be used as the
benchmark portfolio against which your portfolio’s returns should be compared. Moreover, comparing
only the percentage returns of your portfolio with some other portfolio is only half the story because the
risk has been ignored. In fairness, the benchmark portfolio against which your portfolio returns are
compared should have the same risk as your portfolio; and only then it is fair to compare your portfolio’s
returns with the Rp of the benchmark portfolio.

Another problem is that returns of portfolio can be affected by cash inflows and outflows experienced by
a portfolio during the evaluation period (holding period), and that issue is relevant to open-ended mutual

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TA: Ms Mahen Chaudhry and Ms Roha Asim

funds. Realized returns for any holding period on a portfolio which does not experience cash inflows and
outflows, such as a closed end mutual funds (such as the 4 portfolios that you constructed for your
class project) are easy to calculate as:

Realized Rp= [(End Value - Beg Value)/Beg Value] + [ Dividend/Beg Value]

Or if we add dividends in the ending value then we can write simply as :

Realized Rp= [(End Wealth – Beginning Wealth)/Beginning Wealth]

While end value or beginning value of a portfolio is market value of shares in the portfolio if portfolio is
unlevered; but End OE and Beg OE is used if portfolio is levered. If cash dividends are received during
a period then these are included in the wealth at the end of period (W 1 ); and then realized rate of return
earned by a portfolio can be written as:

Realized Rp for a closed end portfolio = [(W1 - W0) /W0 ]

For your group project that was spread over 10 weeks you would calculate Rp for 10- weeks holding
period as:

Realized Rp= [(W10 –W 0)/ W 0]

But all portfolios are not like closed- end mutual funds where funds are given to portfolio manager once
and then no further funds are given or taken away from her during the period under evaluation. A lot of
portfolios, such as pension funds, provident funds, open ended mutual funds, etc, do receive regular
inflows and experiences frequent outflows during one year or any other period of interest. In Pakistan
most of the 200 plus mutual fund portfolios are open ended. Due to inflows and outflows during the
investment horizon, end value may be affected . For example open-end mutual funds , such as NIT,
experience daily inflow and out flow of cash as investors every day buy units of NIT (shares of portfolio)
and also some investors surrender (sell back) the units to NIT. Therefore difference in ending values of
any 2 open ended portfolios do not give a clear proof that one portfolio manager was better than the other
manager if portfolios were open ended.

Example: time weighted annual Rp is calculated, then holding period Rp for 3 period is calculated for 2
portfolio managers as shown below.

YEARS
Manager A Year 1 Year 2 Year 3 Year 4

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TA: Ms Mahen Chaudhry and Ms Roha Asim

Value before in and outflows 100 240 126 138.6

In(out) flows 100 (100) 0
Invested amount 200 140 126
Ending Value 240 126 138.6
Rp= (End Value - Beg Value)/Beg Value (240 -200)/200 (126 - 140)/140 (138.6 – 126)/126
20% -10% 10%

Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1

=[(1+ 0.2)(1+ -0.1)(1+ 0.1)] - 1 = 18.8% per 3 -years holding period

This was time weighted holding period return and it is the correct method for open ended portfolios’
holding period Rp calculations.

Please note; The above Rp for 3-yar holding period is time-weighted Rp. That means growth in wealth is
18.8% in 3 years. And some one can incorrectly calculate 3-year holding period returns as : (138.6 –
100 )/100 = 38.6% per 3 years; and may conclude that 38.6/3 = 12.86% per year on average was earned
as Rp by this portfolio over a three year period. It is incorrect because it ignores timing of cash inflows
and out flows of this portfolio. Please note also that in this case correct arithmetic mean Rp per year is:
(20 + -10 + 10)/3 = 6.66% per year.

YEARS
Manager B Year 0 Year 1 Year 2 Year 3
Value before in and outflows 100 120 198 107.8
In(out) flows 0 100 -100
Invested amount (Beg Value) 100 220 98
Ending Value 120 198 107.8
(120 -100)/100 (198 – 220)/220 (107.8 - 98)/98

Rp= (End Value - Beg Value)/Beg Value 20% -10% 10%

Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1

= ((1+0.2)(1+ -0.1)(1+0.1)) - 1= 18.8/ per 3-Year holding period. It is time-weighted

3-year holding period Rp.

And some one can incorrectly calculate 3-year holding period returns as : (107.8 – 100 )/100 = 7.8% per
3 years; and may conclude that 7.8/3 = 2.6% per year Rp was on average earned by this portfolio over a

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

three year period. Please note also that in this case also the arithmetic mean Rp per year is: (20 + -10 +
10)/3 = 6.66% per year, not 2.6%.

In the above example of 2 open –ended portfolios for 3 year holding period please note that both
portfolio managers began 3-year period with 100 million, both managers experienced during three years
inflows of 100 and out flows of 100 million; though the timings of inflows and out flows were different
for two managers. And two managers ended with very different ending market value of shares in their
respective portfolios. Can we say that manager A has performed better than manager B because ending
value was greater after 3 years for manager A ? The Answer is a resounding NO. The fact is that both
manager earned exactly same time weighted holding period Rp, and therefore their performance was
exactly same as far as earning the returns was concerned.

Therefore, for the open ended portfolios which experience cash inflows and outflows during the
evaluation (holding) period, the performance cannot be judged by comparing beginning value with the
ending value; rather the TIME WEIGHTED holding period returns for the periods under evaluation must
be calculated to decide which portfolio gave better returns. In the previous example Manager A started
with 100 and ended after 3 years with 138 while during 3 years she experienced inflows of 100 and
outflows of 100. Manager B also started with 100 but ended after 3 years with 107.8 and experienced
inflows of 100 and outflows of 100 during this period. Though 2 managers ended with very different
ending value for their portfolios, yet their performance was exactly same when compared on the basis
of holding period returns (calculated as time weighted returns) over the three year period. Otherwise if
you had calculated 3-year holding period Rp as:

(End value - Beginning value) / Beginning value

3-year Rp for portfolio manager A = (138.6 - 100) / 100 = 38.6%; and per year Rp = 38.6/3 = 12.86%

3-year Rp for portfolio manager B = (107.8 - 100) / 100 = 7.8%; and per year Rp = 7.8/3 = 2.6%

And therefore you would have concluded that manager A has performed better; but actually that would be
an incorrect conclusion. Using beginning value and ending value of portfolio is valid method only for
portfolios which experience no interim cash inflows and outflows, such as closed ended mutual funds, but
the portfolios given above managed by manager A and B were OPEN ENDED PORTFOLIOS.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

Please note that for your group projects, all the 4 portfolios were closed-
ended.

But in the example given above, both portfolios experienced cash inflows and outflows, though timing of
inflows and out flows were different; these were open-ended portfolios. Therefore correct method was
comparing their time weighted holding period returns of 3 year holding period; which were exactly the
same for both portfolios (18.8% for the three- year holding period). Therefore you would conclude that
both managers performed exactly the same. This hypothetical example serves to highlight the complexity
involved in making sensible comparison of portfolio returns, while leaving comparison of their risk
undiscussed. But a better method should include consideration to both risk and returns while comparing
performance of 2 portfolios

How to Include Portfolio Risk in Portfolio Performance Evaluation

As indicated already, the comparison of only the returns earned by portfolios is a complex issue; but more
importantly such a comparison of returns alone is not sufficient to make reasonable judgment about the
performance of a portfolio: risk must also be considered. By comparing realized Rp of a mutual fund
with Rp of a randomly built portfolio whose risk was same as the risk of that mutual fund it was found, in
a study by Blume, that average Rp of mutual funds was less than the Average Rp of randomly built
portfolios of similar risk. This finding implies that when general public gives money to professional
portfolio managers of mutual funds then general public does not earn better returns compared to a
randomly build portfolio of the same risk which is built by choosing stocks blindly without any
professional expertise. This finding raises question about the ability of professional money managers to
offer superior money management services to the general public; because general public entrusts their
money to professional money managers in the hope of earning higher rate of return. These findings also
raise question about the justification for the fees charged by professional money managers from their
clients, such as fee charged by mutual funds from the general public as front end load or back end load
when investors buy and sell respectively shares of mutual funds (usually such shares are called units).
And these fees can be substantial, ranging from 1% to 5% of investors’ funds. In Pakistan, mutual funds
are managed by an Asset Management Co (AMC); and mutual funds and the AMC are 2 separate legal
entities; with their own income statements and balance sheets. The Asset Management Co (AMC)
charges a management fee from the mutual fund Co; and this fee is the biggest operating expense of a
mutual fund co as mutual fund co does not have its own employees, AMC gives management services of
making and managing portfolio to the mutual fund co.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

Please note in the above mentioned Blume’s study the benchmark was randomly built portfolios of the
same risk level as the risk of a mutual fund under consideration. Some researchers have proposed to use
all other professionally managed portfolios in that country as benchmark. To perform such comparison,
rankings in percentile terms are used. First see in which percentile fall returns of your portfolio among all
other professionally managed portfolios, i.e. mutual funds. Then see in which percentile falls risk of your
portfolio among all other professionally managed portfolios. For example : last year your portfolio’s
realized Rp was 15% and SDp was 5%. And your portfolio return was in 75 th percentile . So 75% of
managers got lower Rp than you. Your portfolio’s SD p (total risk) was in 85th percentile. So 85%
managers assumed lower risk than you. Result : in terms of returns you were among the top 25%
portfolio managers; but in term of taking high risk you were among the top 15% portfolio managers. So
your risk was higher than return when compared with all other portfolio managers. If your portfolio risk
were also in 75th percentile as you Rp was, then it was ok. On the other hand if your portfolio risk were in
60th percentile and Rp were in 75 Th percentile then you would be recognized as superior money manager
who earned relatively higher returns by taking relatively lower risk; and relative here means relative to all
other professionally managed portfolios.

Four Commonly Used Techniques Of Evaluating Portfolio

Performance

Though there is no consensus about one acceptable method of evaluating performance of a portfolio, yet
certain methods of portfolio performance evaluation have gained currency and are widely used both by
practicing managers and academicians and researchers. Four such methods are presented below.

Sharpe’s Excess Return to Variability Ratio (Sharpe’s Ratio)

(Rp – Rf) / SDP

Please note Rp and SDp are respectively realized annual rate of return and total risk of portfolio. This so
called the Sharpe ratio is calculated for each portfolio for a given period such as one year, and portfolios
are ranked according to this ratio: higher the ratio, better is the performance of portfolio, and higher is its
rank compared to other portfolios. You can read this ratio as excess portfolio returns per unit of total risk.
But a close examination would tell you that actually the ratio is
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

(Rp - Rf ) / (SD p - SD Rf) that is rise / run = slope of a straight line

and SD Rf is not shown because it is zero by definition. It means this ratio is in fact slope of a straight
line emerging from Rf and passing through portfolio P, and extending till infinity. This line is called
Capital Allocation Line (CAL) of that particular portfolio, in this case it is CAL of portfolio P.

Please remember from previous lectures that when you divide your OE between a risky portfolio (in that
case it was portfolio M) and a risk free asset and build multiple portfolios in this manner, then all such
portfolios fall on a straight line called CML. Also remember that the reason for these portfolios falling on
straight line was the perfect positive correlation between a risky portfolio (M) and portfolio built by
investing in Rf asset and M. You saw in previous notes this fact by doing exercise. Similarly if we use
any other risky portfolio such as portfolio P instead of portfolio “M” then many portfolios by investing
some OE in a risky portfolio P and some OE in risk free t-bills can be built , and these portfolios would
also arrange themselves on a straight line as shown below , and such a straight line is termed CAL
(Capital Allocation Line) for portfolio P.

You know that slope of CML is: (Rm - Rf)/ SDm. And it can be called Sharpe ratio of CML. And if a
portfolio has Sharpe ratio higher than the Sharpe ratio of CML, then such a portfolio has beaten the
market, that is CML, on a risk adjusted basis.

CAL is straight line

made by dividing
OE in portfolio P
15 Rp P CML and Rf

Rs 10 S M

Rf = 3 CML is straight line made by dividing

OE in portfolio M and Rf

SD Rf = 0 SDp and SDs= 5% SDm

All portfolios on CAL of portfolio P can be built by investing in P and RF, and each dot on CAL is a
portfolio. As slope of CAL of portfolio P is higher than slope of CML, so CAL of portfolio P offers a

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

superior risk return combination. So if Sharpe ratio of a portfolio is higher than slope of CML (Which is
Sharpe ratio of CML), then such a portfolio has beaten the market on risk adjusted basis as it lies on a
straight line called CAL of portfolio P which has higher slope than CML slope. And therefore gives
higher return than a portfolio on CML with same risk. In the case shown above in graph P and S
portfolios have same risk but P gives higher retun for same risk than S, because Sharpe ratio of portfolio
P is greater than sharpe ratio of S as shown below

In the graph shown above, according to CML a portfolio with SDp = 5% should have Rp shown as S, but
actually with that much risk portfolio P has shown higher Rp, that is the vertical distance between
portfolios P and S. Rp 10% shown of portfolio S should have been earned by taking risk (SDp) =5% if
portfolio was built as efficient portfolio which required investing only in 2 securities , namely market
portfolio M and risk free asset . But apparently manager of portfolio P has not built her portfolio in that
manner and probably has decided to do stock selection, resulting in a portfolio of , say, 10 stocks based
on her security analysis. Of course this portfolio P is inefficient, of course it has diversifiable risk
present in it, and of course portfolio manager has done all this deliberately in the hope of attaining a
higher Sharpe ratio than the Sharpe ratio of CML. So Rp of portfolio P is 15% that is higher than Rp of
portfolio S, though both portfolios have same total risk, Sd, of 5%; and resultantly Sharpe ratio of
portfolio P is higher than Sharpe ratio of portfolio S.

Sharpe ratio of Portfolio P = (15 – 3)/ 5 = 12/5 = 2.4

Sharpe ratio of Portfolio S , which on CML, = (10 – 3) / 5 = 7/5 = 1.4

Thus portfolio P is superior than portfolio S

Since many portfolio managers in real life do not follow the dictates of modern portfolio theory, and do
build their portfolios by doing stock selection based on their security analysis expertise; therefore it is
sensible to compare their respective Sharpe ratios with each other, and do the ranking of their
performance according to their Sharpe ratio. Please note that Sharpe ratio does give consideration to
both the returns and risk of a portfolio. In fact it is measuring excess returns of portfolio per unit of
its total risk.

As shown in graph above, for 5% risk (SD) the CML is suggesting that an efficient portfolio, built by
investing some of your OE in Rf and some in M, should have a return of S (say its returns are 10% ); but
portfolio P, which is tailor made portfolio, probably composed of a few stocks, has earned higher returns
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TA: Ms Mahen Chaudhry and Ms Roha Asim

shown as Rp (say its returns are 15%); so portfolio P has beaten the market on a risk adjusted basis. For
example if Rf is 3%, and based on total risk (SDp) 5%, CML tells this portfolio should have a ROR of
10% but actually it earned ROR of 15%; then according to the CML, Sharpe ratio of portfolio P should
be:

(Rp –Rf )/ SDp = (10 – 3) /5 = 7 /5 = 1.4/1 =1.4 which is also Sharpe ratio of portfolio S

but actually portfolio P has Sharpe ratio of

( Rp – SDp ) /SDp = (15 - 3) / 5 = 12 /5 = 2.4 /1 = 2.4

So if risk were one unit or 1% SDp, the excess returns of portfolio P should be 1.4 according to CML;
but actually excess return of portfolio P are 2.4%. Therefore portfolio P has earned higher excess returns
per unit of risk than was suggested by CML. You can say:”portfolio P has beaten the market on a risk
adjusted basis”, or in other words portfolio P falls on a straight line (CAL) which has higher slope, that is
2.4 than the slope of CML that is 1.4

Sharpe ratio is used to rank portfolios: higher the ratio better is portfolio’s risk adjusted returns. For
example your portfolio’s Sharpe ratio is 10%, and Sharpe ratio of your friend’s portfolio is 13%; then she
has outperformed you on a risk adjusted basis. In other words if both portfolios have SDp of 1%, then
her portfolio’s excess returns are 3 percentage points better than your portfolio’s excess returns. Please
note that excess returns refer to Rp – Rf. For comparison purposes excess returns of portfolio are more
meaningful than the Rp, because everyone can earn Rf, so the relevant measure for returns is excess
returns, i.e., Rp – Rf. Therefore question boils down to : which of the 2 portfolios earned more excess
returns if total risk of two portfolios was same? The answer is given by Sharpe’s ratio. Please
calculate Sharpe ratios for all 4 portfolios that you are managing for your project and then
rank them first, second, third, and fourth on the basis of their Sharpe ratio. But be careful to
use 10 week holding period Rp and 10 week SDp, from weekly Rp data of 10 weks the SD you
would calculate would be a weekly SD, so you multiply that SD with under root of 10 to get SD
of 10 weeks so that it is comparable with Rp of 10 week holding period

Treynor Excess Return to beta Ratio (Treynor Index)

(RActive –Rf )/ B Active = (15 – 3) / 2 = 12 /2 = 6 / 1 = 6

And passive portfolio has

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

( RPassive – Rf ) / B Passive = (18 - 3) / 0.9 = 15 /0.9 = 16.6 / 1 = 16.6

Then passive is ranked first and active portfolio is ranked second.

This Treynor ratio measures excess returns per unit of relevant risk, only difference from Sharpe ratio is
the use of relevant risk (beta) instead of total risk (SDp) in the denominator of the Treynor ratio. Higher
the Treynor ratio, better is portfolio’s risk adjusted returns, and therefore better is its performance. Rank
the portfolio according to this ratio. Please calculate Treynor ratios for all 4 portfolios that you
are managing for your project and then rank them first, second, third, and fourth on the basis
of their Treynor ratio.

Differential Returns Using SML

Find Expected R of Active portfolio using SML (CAPM) as

Expected R Active = Rf + (RM - Rf) * Beta Active

For example it comes out as shown below

Expected R Active = 5 + (10 - 5)0.8 = 9%

If your Active portfolio actually earned in the 10 weeks holding period ROR of 11% then:

Differential return of Active portfolio from SML = Actual Rp – Expected Rp

= 11 - 9
= 2%.

As your differential returns are positive, therefore you have beaten the market on a risk adjusted basis. It
means that based on the relevant risk (beta) of your portfolio (0.8), your active portfolio should have
earned 9% ROR but actually it earned 11% ROR in 10-week holding period, thus beating the market on a
risk adjusted basis. On the graph, you active portfolio actual ROR, as a dot, would appear above the
SML where beta is 0.8, and the vertical distance between the dot and the SML is differential return of
your active portfolio.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Mahen Chaudhry and Ms Roha Asim

Please Rank your 4 portfolios on the basis of differential returns. Higher differential return means better
performance of portfolio manager, and positive differential returns means portfolio has beaten the market
on a risk adjusted basis whereas in this context risk means relevant risk or beta of portfolio. Please
calculate differential returns for all 4 portfolios that you are managing for your project and then rank
them first, second, third, and fourth on the basis of their differential returns from SML. Please note
that your Index Portfolio would have zero differential returns because Rm used in SML equation is

actual return earned by your index portfolio during the 10 –week holding period. You did so because
you were making an ex-post facto (after –the-fact) SML for the last 10-weeks; therefore expected RM
is same as Actual RM, and therefore differential return from SML for the index portfolio would be
zero.

Differential Returns using CML

Risk adjusted returns according to capital market theory are calculated from CML, which means, for
example for you passive portfolio , that expected R Passive:

Expected Rpassive = Rf + {(Rm - Rf) / SDm}*SDpassive .

Compare: Actual realized Rpassive for 10-week holding period with expected R passive from CML equation.
If actual Rpassive is greater than Rpassive estimated from CML, then differential returns of portfolio are
positive, and you as portfolio manager did better than market for the given level of total risk, in other
words your passive portfolio has beaten the market on a risk adjusted basis. On the graph your passive
portfolio’s actual ROR for 10-week holding period , as dot, would fall above the CML. For example :
Last year’s Rf = 5%, Rm = 10% (10 week holding period OR of index portfolio), SDm = 20% (10
weeks SD of index portfolio), total risk of your portfolio SD passive (10 week SD of your passive portfolio
calculated as weekly SD from weekly data of ROR of 10 weeks then multiplying that SD with under root
of 10 would give you SD of passive portfolio for 10 week) = 15%.
Expected Rpassive from CML is:

Expected Rpassive = 5 + [(10 - 5) / 20]*15

Expected Rpassive = 8.75%
Your passive portfolio’s 10 week holding period ROR was 10%
Differential return of passive portfolio from CML = Actual R passive - Expected Rpassive from CML
= 10 - 8.75
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TA: Ms Mahen Chaudhry and Ms Roha Asim

= 1.25
Again you have beaten the market on a risk adjusted basis. According to CML, for the given level of
total risk (SDpassive) of 15% your passive portfolio should have earned 8.75% ROR, but actually it earned
10% ROR, thus beating the market on a risk adjusted basis. On the graph paper Actual ROR of Passive
portfolio would appear as a dot above the CML exactly above where the SD on x-axis is 15. The vertical
distance between CML where SD is 15 and your dot of actual ROR of passive portfolio is 1.25 %age
points and that is the differential return of passive portfolio. Please Rank the portfolios based on their
differential returns from CML, higher the differential return of a portfolio from CML , the better is the
performance of that portfolio on a risk adjusted basis..
Please calculate differential returns for all 4 portfolios that you are managing for your project and
then rank them first, second, third, and fourth on the basis of their differential returns from CML.
Please note that your Index Portfolio would have zero differential returns because in CML equation
Rm used by you is the actual 10-weeks holding period return of your index portfolio. You did so
because you were making an ex-post facto (after –the-fact) CML for the last 10-weeks therefore actual
RM and Expected RM from CML would be same and their differential would be zero for the index
portfolio

It is important to note that the 4 methods of portfolio performance evaluation discussed above may not
result in the same ranking for your 4 portfolios; but that should not be a cause of concern for you as it was
stated in the beginning of this lecture that there is no one agreed upon method of evaluating portfolio
performance.

Two Investment Management Strategies

Generally there are two approaches to investment strategy, passive and active. The following is brief
explanation of two investment strategies.

Passive strategy:

This is the investment strategy dictated by the modern Portfolio Theory. It says, Invest some of your OE
in the market portfolio (M), that is invest in an index fund and some in a risk free asset ( such as t- bills);
and the resulting portfolio’s expected Rp falls exactly on SML and your portfolio’s risk adjusted
required return are estimated using CAPM equation: Rp = Rf +(Rm - Rf)Bp. Also returns of portfolios
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TA: Ms Mahen Chaudhry and Ms Roha Asim

built in this manner fall exactly on CML. Please note in practice a market- index- mimicking mutual fund
(index fund) is used as a proxy for market portfolio (M). In the presence of risk free asset in the country,
and if risk free lending (by investing in t-bills) and risk free borrowing ( by shorting t- bills) is allowed to
the investors then all portfolios built in the above stated manner are efficient, fully diversified, and have
perfect correlation of their returns with the return of market portfolio. Portfolio of any desired level of
risk or target level of returns can be built using this method of portfolio construction. This method of
building portfolios does not require doing any kind of security analysis (neither technical analysis nor
fundamental analysis ) to identify under-valued or over-valued shares; because all stocks are included in
market portfolio ‘M’, and you are investing a certain portion of your OE in M.

Active strategy:

When you build a tailor made portfolio of a few stocks such as 4, or 10, 50 stocks, you are building a
tailor made portfolio whose composition is different then market portfolio. To build such portfolio
you do stock selection on the basis of your security analysis abilities, i.e., based upon your estimates of
expected Ri and SDi , VARi, COV , EPS 1, DPS1, ‘g’ , P1, and Bi , etc, of different stocks.
i , j Stock
selection is done by you in the hope of beating the market on a risk adjusted basis. That is called active
investment strategy because you are actively selecting stocks to include in your portfolio instead of
investing some OE in market portfolio which includes all the stocks.

Your active investment strategy’s performance should be evaluated by differential returns from SML.
If you manage to show positive differential return from SML, then you have proven that you have
exceptional stock selection abilities.

An investor opting for active investment strategy involves herself in stock selection instead of just
dividing her OE between Rf and M, and she makes portfolios by investing only in a few selected stocks.
Please note that such portfolios in all likelihood are not fully diversified, and diversifiable risk is present
in such portfolios. That means VAR e P is not zero in such tailor made portfolios of a few stocks. On
the other hand, portfolios made by dividing OE between Rf and M are always fully diversified and have
zero VARe P. So doing stock selection means deliberately taking diversifiable risk.

Common sense tells that it is justified for you to take a risk only if extra returns are earned by taking such
risk. Positive differential returns from SML is a proof of earning such extra returns; and if differential
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TA: Ms Mahen Chaudhry and Ms Roha Asim

returns of such tailor made portfolio is positive then it may be considered as reward for taking
diversifiable risk, or in other words, reward for doing superior stock selection.

On the other hand CAPM, as a theory, says that the market does not reward diversifiable risk; so no such
extra returns can be earned according to CAPM from tailor made portfolios of a few stocks. According to
CAPM only taking the relevant risk (beta) is rewarded by the market in the form of higher returns.
Therefore in CAPM equation it is beta (the relevant risk) which is independent variable; and returns
depend on it: higher relevant risk taking should result in higher returns according to CAPM. In the jargon
of finance: market rewards only the taking of relevant risk; or, market prices only the relevant risk.
Therefore attempt to do stock selection is useless according to CAPM framework.

But you can prove you have superior stock selection ability if your tailor made portfolio of a few stocks
earns positive differential returns from SML, that is, its actual returns fall above SML. For example, for
the beta of your portfolio, CAPM was saying returns should be 12% but you earned 15%, so the 3 %age
point positive differential returns of your portfolio can be viewed as reward for taking diversifiable risk,
or viewed as proof of your superior stock selection abilities. This is also termed as beating the market on
risk adjusted basis.

Active strategists deliberately build inefficient portfolios (and not fully diversified portfolios) on the basis
of their presumed superior stock selection abilities. Adopting active investment strategy, therefore,

means you do not subscribe to the conclusions of portfolio theory; because portfolio theory’s final
recommendation is to build efficient portfolios, and in the presence of risk free lending and
borrowing, such efficient portfolios of any desired level of risk or return can be built just by dividing your
OE between M and Rf; and such efficient portfolios always fall on CML as well as on SML; and you can
use CML and SML equations to estimate expected returns or risk of such portfolios. And such portfolios
are fully diversified, have perfect positive correlation of their return with Rm.

In fact according to CAPM all investors should invest only in one Markowitz risky portfolio, i.e., the
market portfolio ,“M”, and in a risk free security (t-bills) ; and by doing so each investor can build her
personal optimal portfolio of any desired level of risk or desired level of returns . For example you can
build in this manner an efficient portfolio with expected Rp of 29%, or 129%; a portfolio whose beta is
0.9 or beta of 1.9 ; and you can do so just by changing weights of market portfolio (X m) and weight of
risk free t-bills (XRf) in your personal optimal risky portfolio.

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TA: Ms Mahen Chaudhry and Ms Roha Asim

Many research studies indicate that no investment manager has shown superior stock selection abilities
because that requires a managers to show a track record of consistently beating the market on a risk
adjusted basis for a number of years, that is, showing positive differential returns from SML for number
of years, not just in one year. In other words, a portfolio manager has to show that year after year positive
differential returns from SML were earned by the portfolio she managed. Since such evidence has not
been given by any professional portfolio manager, therefore, the portfolio theory still holds; and
regardless of talk about hot stocks, the empirical evidence does not support the claims of superior
performance made by active strategists, also called, stock selectors or stock pickers.

The Final Conclusions Drawn From Portfolio Theory

It should be clear by now that in the absence of risk free security, portfolio theory gives precise answer to
question 1 and 2, namely, what to buy and what combination to buy ? It does so by giving exact weights
(Xi) of stocks included in Markowitz efficient risky portfolio selected by an investor as her / his optimal
portfolio. But in the presence of risk free security and permission for risk free lending and borrowing, the
portfolio theory again gives precise answers to question 1 and 2 by recommending to invest only in 2
securities, namely market portfolio and risk free t-bills; and the theory gives precise answers about the
weights of efficient portfolio in the form of X m and X Rf for your desired level of return and risk (Rp or
Bp). Therefore the last word of advice based upon the portfolio theory is to adopt a passive investment
strategy, avoid stock selection, build your optimal portfolio for your desired level of risk (beta) or desired
level of return by investing only in 2 securities, namely, market portfolio (M) and risk free security (Rf) ;
and you will have an efficient portfolio, a fully diversified portfolio, and a rightly priced portfolio without
worries of holding an overvalued or undervalued portfolio.

Unfortunately these conclusions of portfolio theory are not stated in such stark and almost astonishing
terms in any text book. Advisory research reports prepared by the brokerage houses also do not give this
kind of advice. In case of brokerage houses, one can understand their reluctance to tow this line of
argument because their business compulsion of earning commission revenues arising from frequent

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trading by the investors may prohibit them from recommending such passive investment strategy to their
clients.

The third and last question raised in the very first lecture was: When to buy ? There is ample evidence
based on research findings that ability to correctly time the buying or the selling of stocks, or ability to
time the entry and the exit from the market, is not demonstrated by the followers of any of the so called
systems of technical trading. Therefore regardless of the claims made by the proponents of various
approaches / methods / systems/ rules of technical trading, none has shown consistently the ability to
identify correctly the time to sell or time to buy. It must be stated that any time is good time to buy, as
long your estimate of expected return of market portfolio is reliable enough. Similarly, the logic of
portfolio theory would dictate, that any time is good time to sell.

It is important to emphasize that for the results of portfolio theory to be realized, at least a one year
holding period is necessary; that is why CAPM is called a single period model: inputs of CAPM, namely
Rf and Rm, are annual expected returns, therefore result of CAPM , namely expeted risk adjusted Rp, is
also annual expected return. It also makes sense that to see the results of investment in corporate shares,
one should hold shares for at least one year to give the corporate managers a chance to show their
performance in terms of managing the corporations and then investor in shares should also allow for the
time it takes for the corporate performance to translate into outcomes which impact investors returns,
namely, dividends and capital gains. In other words, the idea of frequent trades, or as they say in industry
jargon, frequent rebalancing the portfolio, is also not recommended by the portfolio theory. “Buy and
hold at least for one year” should be the mind set of investors following the portfolio theory.

This explanation still leaves the behavior of stock pickers un-explained; and the next lecture would
discuss the logic underlying the stock selection behavior of the active investors.

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